Problem:
Prepare a single EBIT–EPS graph showing the current and two alternative capital structures.
…..Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital structure, Lewis has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures—A (30% debt ratio) and B (50% debt ratio)—that he would like to consider.
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Capital structurea
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Current
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A
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B
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Source of capital
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(10% debt)
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(30% debt)
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(50% debt)
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Long-term debt
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$1,000,000
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$3,000,000
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$5,000,000
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Coupon interest rateb
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9%
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10%
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12%
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Common stock
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100,000 shares
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70,000 shares
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40,000 shares
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Required return on equity, ksc
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12%
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13%
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18%
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aThese structures are based on maintaining the firm's current level of 510,000,000 of total financing.
binterest rate applicable to all debt.
cMarket-based return for the given level of risk.
Lewis expects the firm’s earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.